Seriously, Jesse Eisinger needs to stop writing about the Volcker Rule, because he has absolutely no idea what he’s talking about. His latest article makes a number of egregious errors, but I want to focus on the one that’s most demonstrably untrue. Eisinger writes: (emphasis mine)

The Congressional authors of the Volcker Rule worried about this very thing [i.e., the potential to move prop trading into the bank’s treasury operation], and you can trace their concerns through their drafts. The original language of the rule had a broad exception: banks couldn’t trade for their own account, but they could hedge to mitigate their risks.

The authors quickly realized that the exemption was absurdly broad. After moving these businesses to other divisions, banks would then argue that their bets were either market-making activities or simply hedges that offset risks.
...So Congress tightened the language. It wrote that the hedges had to be specific. When the Dodd-Frank financial reform law came out, the Volcker Rule provision defined “risk mitigating activities” as trades that were “designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.” No macro-hedging, only micro-hedging. That is the will of Congress.

This is patently untrue on so many different levels. For one thing, Eisinger conveniently omits the first part of the hedging exemption, which explicitly allows portfolio hedging. But we’ll get to that. First, let’s do something that Eisinger clearly didn’t do — actually trace the hedging exemption through Congress’s drafts.

Here, in chronological order, are Congress’s main drafts of the hedging exemption in the Volcker Rule (with the key language that was added to each version in red):

“(C) Risk-mitigating hedging activities designed to reduce the specific risks to a banking entity or nonbank financial company supervised by the Board.”

Draft 4 (Final Language) — Final conference report (H. Rept. 111-517), which was signed into law on July 21, 2010:

“(C) Risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.”

Look at the difference between the last two drafts — as you can see, contra Eisinger, all of the changes in the final version substantially broadened the language of the hedging exemption.

The key is the language that Eisinger conveniently omitted in his article, which specifies that banks’ hedging can relate to “aggregated positions, contracts, or other holdings” — i.e., portfolio hedging. Note also that the final version clarifies that “specific risks” does not mean specific positions, because the “specific risks” that banks must be hedging can also relate to “aggregated positions, contracts, or other holdings.” The interest rate risk in a bank’s mortgage portfolio, for instance, is a “specific risk” that relates to aggregated positions. That’s what portfolio hedging is — it’s hedging the risks of the bank’s aggregate positions.

Eisinger clearly does not understand this distinction — he claims, falsely, that Congress “wrote that the hedges had to be specific.” Not true. Again, it’s the risks that have to be specific, and those risks can relate to aggregate positions.

This is exactly what Congress intended. All of this language about “aggregated positions” was added between Draft 3 and Draft 4 specifically to ensure that portfolio hedging would be allowed under the Volcker Rule. Indeed, there’s no other logical explanation for why Congress added the language about hedging “aggregated positions” between Draft 3 and Draft 4.

Thus, as you can see, it was clearly “the will of Congress” that portfolio hedging be allowed under the Volcker Rule.

So why did Eisinger claim that portfolio hedging is prohibited under the statute when it’s so clearly allowed? Probably because it allows him to self-righteously criticize both the banks and the regulators, and to present himself as far too knowledgeable and savvy to be fooled by all this fancy talk about “portfolio hedging.” (This kind of posturing is becoming increasingly common.)

But the reality is that portfolio hedging is 100% allowed by the Volcker Rule’s statutory language, and this is exactly what Congress intended — and anyone who tells you otherwise doesn’t know what they’re talking about.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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